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The case for lowering taxes

As macro policies go governments have two main tools to implement them: fiscal and monetary policy. Since the start of the current crisis in 2007 both of them have been used in an attempt to push up aggregate demand. Until now the results are not what anyone would reasonably expect from looking at the public debt growth and from key policy rates near zero. Basically, policy makers supplied fiscal shocks one after another (increased government expenditures) while monetary policy accommodated those shocks by increasing money supply (lowering interest rates).

Going forward economists are offering depending on their convictions and political aspirations either more government spending, an even looser monetary policy or a combination of the two.

However, there only few voices advocating lower taxes. Why is this so and how would this work?

Cutting taxes leads to higher cash balances for the private sector (households and companies) but also for the public sector employees and state owned enterprises. There are two main immediate effects of lowering taxes are: higher cash balances and lower government revenues. Regarding the first one those higher cash balances will either be spent or saved. In the same time the government can continue spending as before or cut spending to adjust for the lower revenue.

Let’s walk through the 4 cases and see what is the expected end result for each one of them.

In the first case extra cash balances are spent and the government continues to spend as before. The effect from higher consumption will lead to economic growth in the very short term. This effect is amplified by credit growth as more people and companies qualify for more debt. In the same time the government will have to borrow to pay for the same/increased spending. In the first years revenue will not fall as much on the back of economic growth. However, over time the government will have to borrow more increasing the public debt. As public debt grows financial markets will start increasing the cost of funding. The end result will just be default unless economic growth will be higher than the interest rates at which the government borrows. We know that beyond some level of growth this outcome is impossible.

Turning to the second case, when the public saves and the government continues spending as before, the main difference is that we do not benefit from the short term growth (details in the 4th case). Thus the end result, default, is achieved much faster.

The third case is the one where cash balances are spent and the government cuts spending in response to lower revenue. Thus we benefit from economic growth but more importantly from a lower budget deficit which in turn will lead to a lower and lower public debt. Lower public debt means lower interest rates which will put the economy on a higher potential growth path increasing the welfare of all citizens.

Finally, the fourth case will lead to the same result as the third one but with some delay as in the first instance cash balances are saved. This will lead after some time to lower cost of funding due to higher pool of savings and then to increased investment which will lead to economic growth. Again, we end up with improved welfare but it will take longer than in the case when cash balances are spent immediately.

The four cases are presented in the table below.

Private Sector/Public sector employees

Government

consume/continue public spending

default but delayed by short term increase in growth

Save/continue public spending

Default faster as there is no immediate growth effect

Consume/cut public spending

Increased welfare faster due to immediate growth effect from consumption

Save/cut public spending

Increased welfare but after a longer period as there is no immediate growth effect

From the table it is easy to see that the best outcome is when cash balances are spent and government cuts spending while the worst outcome is when the extra cash balances are saved while the government continues to spend as before.

Of course we do not know ex ante which of the 4 cases has a higher probability. What we do know, and it is very important, is that irrespective of what the private sector does lower spending due to a cut in taxes will lead to improved welfare.

Why then we do not talk about lowering taxes as a solution to get out of the economic crisis and promote growth? My answer is that policy makers know that they will not cut spending in response to lower taxes. In fact they also know that every 4 years they will have (from their point of view) increase spending to ensure re-election. Thus, although we all know what the best outcome is the behavior of the policy makers, dictated by their objective function, gives the highest probability to the default scenarios. Under these circumstances it is not optimal for policy makers to advocate lower taxes.

Nevertheless, the society should strive to change this and push policy makers towards lower taxes and lower government spending as the best solution to achieve higher welfare. One way is to vote most of the time those candidates that promote this policy mix – lower taxes, lower public spending. Over time we will end up in the lower part of the table presented above.

Finally, I have not talked about monetary policy at all. Does it matter what monetary policy does in this case? Let’s see. To same extent it does, similar to the case when fiscal stimulus takes the form of higher government spending. Much like in that case monetary policy will have to accommodate some of the lower taxes. But not as much as in the government spending case. The really positive outcome of lower taxes is that households and companies can increase consumption and investment via more credit. Thus the work of monetary policy will be done by the banking sector and in this way we end up with lower inflation expectations.

Lowering taxes followed by a cut in government spending in the same proportion is a superior solution to increasing government spending when we try to maximize the welfare of the economy. This result is derived from lower inflation expectations and lower probability of default over time.

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19 thoughts on “The case for lowering taxes”

@Florin
” while the worst outcome is when the extra cash balances are saved while the government continues to spend as before.”
That’s only in the short term. In the long term, the people who saved will consume or invest their money.

“The really positive outcome of lower taxes is that households and companies can increase consumption and investment via more credit. ”
I hope that they will not be that stupid.:)
If the taxes are lower, you(as a person or company) should pay your debts first. Second, if you have any left over cash, you should invest it into means of production so you can make even more cash. The invested cash would have gone anyway to the state. By squandering it on consumption, you are doing no good to you in the long term.

@adrian
You are right. But if you do not have debt than or if you did not qualify for debt before than lower taxes will help you in this respect. Or course you may believe that debt is bad but I look at debt as money.And I always said that for those that have too much debt there is always bankruptcy.

@Florin
No, debt is not bad. It just that most of the time is bad or unnecessary.

Humans in general have a hard time thinking in terms of debt and interest. Most of the time, they overestimate or underestimate a bunch of variables like: time to market for a product, profitability, random problems, additional unforeseen issues. They also tend to look only at the bright side of the future and ignore the possible downfalls and stumble-blocks.

Not many plans survive the test of reality. And when you have taken money, you are basically on borrowed time. You have to make something work with other people’s money until you run out of cash.

Also, it’s nothing easier than to spend other people’s money. It’s very easy and it’s likely that you will make bad decisions when you have money in your hands instead of fire in your belly to make something happen right now.

Let’s say that you want to start a business and use outside cash. Then you take the money and you think about spending it. You don’t think about making more. This is especially bad when you don’t have a lot of experience.
Spending other people’s money will never teach you how to earn money.

And if you are already good at making money, you don’t need any to borrow because you are already good at it. You may try to risk it and go for a bigger reward but you don’t have to. You just do it because you want to do it.

***
In my view, debt is good only when you have no choice or when you use it as a bridge for a short while. If you take debt for 3 months, this can be good. If you take on debt for a couple of years, that’s bad. Because you don’t really need it. During this period of a couple of years, you may end up earning money for the bank, that’s literally working for the bank, than for yourself.

In conclusion: You said that debt is money. I say: No, debt is borrowed money. And this is problem. It’s not just money, it’s other people’s money and you have to pay it back with interest.

@Adrian
If you use the “borrowed” money to get a return higher than your interest than it is worth taking the loan.
I have to disagree with you regarding the definition of loan: it is money. Every money is a promise to pay, every money is debt and the other way around.

@Florin
“If you use the “borrowed” money to get a return higher than your interest than it is worth taking the loan.”
There are 2 scenarios.
1. You are a bank or you plan to borrow to give it to someone else with interest. One example is to put it in a bank in a different country with a higher interest rate. Or to buy bonds.

In this situation, it may seem that you will make a profit. But what if the actual country you lend money to will not be able to pay back.

In this case, you are basically creating a chain and hope to work in the end. So it matters a lot if you have a cushion of cash beforehand so you afford a possible loss. Otherwise, there’s a high degree of risk involved.

2. If you are a business, you don’t actually know if it will work out, if you will have a market match with your product.

Sometimes it’s worth it but you can’t know for sure. And the better alternative is to use your own cash and to start small. Risk less and build on your successes.

“Every money is a promise to pay, every money is debt and the other way around.”
Theoretically, yes. Money in circulation was created to serve as legal tender to pay public and private debts.

Practically, not necessarily. Let’s say that you have a sum of money. You decide to hide it some place. Do you actually have to pay that sum again? Nope. You don’t let the money flow back in the system, you just keep the sum for yourself and do nothing with it.

Some other person or institution may have to pay it back, but not you.

You would have lost the actual work or energy that went into getting the money, but you don’t have to pay it as debt. You can keep it forever. If you look at the overall system, yes, the situation is as you have describe it.

@Florin
“Facebook, PayPal etc there are plenty of examples of companies that did well with loans.”
I’m not saying that it doesn’t work. I’m saying that the chance of screwing it up is bigger when you use borrowed money.

That’s the case for a number of reasons:
* our human biases that make people in general prone to error when it comes to the use of money

Let’s take Facebook. How many other social networks, following the same model, actually succeeded? Very few.

I think it’s called survivor-ship bias. That’s the tendency of looking only at the winners. You should look at all the people who attempt a thing and see how many and in which circumstances succeed by following.

Personally, I personally know a few dozen people who have borrowed money both for business and for consumption. Most of them keep paying their rates on time but they can’t seem to lower their principle. Most of their rates are made out of interest.

Also, companies that don’t borrow money aren’t that glamorous because they grow slowly and steadily. Companies that require a lot of cash upfront have to do a lot of promotion to excite their prospective investors who want to invest in the next big thing.

Self funded companies. Obviously, you need money to start something even when you use your own money.

I know a bunch of individuals who earn 6 figures or 7 figures $$$ in profit per year. Some of them are from Romania. They haven’t borrowed any money to start their businesses. I’m not going to mention them here due to privacy.

Here’s a list of companies. They all earn millions in revenues each year. So, they aren’t small. They are mostly on the Internet.

@Florin
“But at some point all of those companies will be listed on the stock exchange, or so the owners hope.”

Some owners seem to be happy with earning a few millions each year in profit. I don’t find anything wrong with that. Do you? 🙂

Yes, you won’t see very often these companies in the press. That’s because they are not the exception. They do it the old way.

Media is hungry for companies who are the exception, the best of the best. The Facebooks, The Youtubes, and other huge sections. The problem is that the chance for you or me to build the next Facebook are very low.

These owners don’t care about becoming big through IPOs and the stock market. And the stock market is not really relevant for everyone. It’s not for everyone.

Btw, I heard that 1 guy had this website(Plenty of Fish – a dating website): http://www.pof.com/
At one point, he earned about $5 million in profit each year with no full time employees.

@Florin
“I still think that without borrowed capital”
I’m not for not allowing people to borrow money at all.

Let’s say that you have a net-worth of EUR 100.000. It makes sense to borrow up to 10-20% of your net-worth. That’s because every time you convert an asset into cash you lose money. So, it makes sense to get directly to money and don’t convert your assets for the time being.

The problem creeps in when people borrow more than their net-worth(or companies more than 50% of their assets).

“without borrowed capital we will advance much slower as entities”
In case of consumers, to pay 2 times the monetary value of the product looks 2 times as slow to me. 🙂

In case of businesses, do you have a large sample of data to prove this? Logically, using other people’s money quickens things but if you make mistakes, it also quickens the rate of loss.

You say “One way is to vote most of the time those candidates that promote this policy mix – lower taxes, lower public spending”. How can this be when 75% of the population depends one way or another on state handouts? Decreased taxation on very small income is too small of a carrot to counteract cancelling of handouts. Except for a small minority, the electorate will never vote as you proposed.

Interesting to bring in monetary policy in to lower taxation discussion. Currently the politicians buy votes via handouts promises which are financed via high taxation. As amount of tax collection can only go so high as a percentage on GDP, once the wall is hit, the gap is financed via inflation (printing press). The central banks rather then staying independent of the political games that usurp people’s wealth, aid and abide political mistakes by transferring purchasing power from one social class to another to the sole gain of political interests.

The role of the independent central bank should also be that of protecting the wealth of productive citizens from politician’s desire of inflation theft. Those citizens that vote politicians who promise and give something for nothing should suffer solely the consequences of their actions. Hard working, prudent law abiding citizens should not be forced to pay for others laziness and electoral incompetence. If the politicians impose extortion level taxes then entrepreneurs and hard working people will vote with their feet and relocate to better countries. No matter how high the tax level, tax collection as percentage of GDP has a limit. If a government runs out of money to give something for nothing in exchange for votes, then it should be allowed to go bankrupt without dragging down with them its prudent and hard working citizens. Those who depend on something for nothing once the government goes bankrupt will learn the hard way that there is no such thing as a free thing and that the way they vote has major consequences as such work ethics will improve and voting based on vote purchasing will decrease to the great benefit of the whole society.

@I-conomics
you say : How can this be when 75% of the population depends one way or another on state handouts?
My point is that the only way to eliminate the political bias towards government spending is to vote, over time, decades, more times governments that promote a smaller government than those that do not. The current situation is the perfect one for policy makers as you rightly point out. The state has a bigger share of workers in the working population than in 2004, from 18% to 30%, and now it strives to increase revenues. This is again a policy to promote state not private sector. A bigger revenue as percent of GDP allows for bigger expenditures.

But this is the current situation and it will not change in 6 months. The problem for Romania is that over the last 22 years we voted left more times than right. This is the basis of my conclusion.

Monetary policy is very important when it comes to fiscal stimulus impact. Only monetary policy can eliminate the inflationary effect of budget deficits and higher public debt. It is also important to note that it does not matter if you use a Sollow growth model or a New-Keynesian one without monetary policy accommodating the fiscal stimulus is almost zero. With 2 years of relaxed monetary policy the impact is less than 50 cents for every dollar spent by the government.